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Global imbalances, international cooperation, and decoupling

Comments prepared for Chatham House / CIGI / Peking University Workshop

Beijing 25 September 2010

Mark Thirlwell Lowy Institute for International Policy

The Plaza Accord

Since we are close to the 25 th anniversary of the Plaza Accord, it does seem rather appropriate to look to Plaza as a possible means of dealing with global imbalances.

There are, of course, other good reasons to refer to this example. The parallels between US­Japan economic relations in 1985 and US­China relations today are quite stark. 1 So, for example, a recent exercise conducted by the IMF looking at reversals in current account surpluses ranks a series of episodes across ten characteristics according to their similarity with conditions as prevailing today: the case of Japan in the 1980s is judged to be one of the most similar, with a score of 7 out of ten (although note that the case of Japan in the 1970s is judged to be even closer with a score of 9 out of 10). 2 Moreover, there have been explicit calls for a Plaza 2.0 to deal with the current global configuration of current account surpluses and deficits. 3

Yet in many ways, the Plaza Agreement makes for a very qualified ‘success’ story.

­ First, it is certainly not clear that all of the participants, including in particular Japan, would view the Plaza Accord positively today. There is a fairly heated debate, for example, as to whether Japan’s great asset bubble boom and bust can be blamed on the deal.

­ Second, it is also not clear whether the agreement actually worked, or even if it was necessary. The US dollar had anyway started to weaken several months before the meeting took place, and as that fall continued afterwards, officials found themselves meeting again, in Paris in 1987, this time to try and stabilise the greenback.

­ Third, the Plaza Agreement relied on a particular geopolitical and geo­ economic configuration. Support of the central role of the US dollar during the post­war period has relied on the contribution of partners’ countries to

1 See for example Haruhiko Kuroda, The "Nixon Shock" and the "Plaza Agreement": Lessons from two seemingly failed cases of Japan's exchange rate policy. China & World Economy 12 (1) 2004. 2 Table 4.5 in International Monetary Fund (IMF), Chapter 4. Getting the balance right: Transitioning out of sustained current account surpluses, in World Economic Outlook: Rebalancing growth. Washington DC, International Monetary Fund, 2010. 3 See for example William R Cline, The case for a new Plaza Agreement. Policy Briefs in International Economics PB05­4. Washington DC, Institute for International Economics, December, 2005. Also C. Fred Bergsten, A call for an "Asian Plaza". The International Economy, Spring 2008.

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defend its international position, beginning with the UK, and then followed by first West Germany and later Japan, and eventually the rich country club of the G7. 4 To some extent, these countries could be seen as repaying the US in kind for its provision of the public good of international security. It seems highly unlikely that the much more heterogeneous membership of the G20 in general, and China in particular, would take this role or this view today.

It’s possible that a better – albeit much more depressing – parallel to today’s circumstances might be the 1933 World Economic Conference held in London. This was a disaster, marked by a near­complete absence of agreement both on the sources of the problems facing the world economy, and on who should be involved in the adjustment process. 5 On both counts, there are some worrying similarities with the current policy debate.

International policy coordination

The case for international policy coordination rests on the idea that there will be circumstances under which two or more countries will agree to a cooperative set of policy changes where neither would wish to undertake the change on its own, but where each expects the agreed package to leave it better off relative to the (Nash) non­cooperative equilibrium. The gains are supposed to come from the spillovers (externalities) that one country’s policies have on the others’. 6

The case for a deal on global imbalances in general, and for a US­China deal in particular, seems to fit in well with this approach. For the US, narrowing its external deficit by squeezing domestic demand means slower growth. For China, shrinking its external surplus by boosting domestic demand risks overheating and inflation. But if US policies to slow domestic demand are accompanied by Chinese policies to boost spending, then the overall adjustment package should look more attractive to both countries. 7

That’s the theory. The practical process of policy coordination is generally thought to involve three stages, each of which can involve serious obstacles to producing an effective agreement: 8

­ Stage 1: each country has to decide what specific policy changes it would like to ask the other to make and what it would be prepared to offer to get them. This involves reaching a common understanding on what the appropriate

4 Robert Gilpin, The rise of American hegemony, in Two hegemonies: Britain 1846­1914 and the United States 1941­2001, ed. Patrick Karl O'Brien and Armand Clesse. Aldershot, Ashgate Publishing Ltd, 2002. 5 Prior to the London Summit of the G20 in April 2009, prominent financial commentators warned that the participants needed to avoid a repeat of London 1933. See for example Financial Times, A survival plan for global capitalism. Financial Times, 8 March 2009. Also Steve LeVine, Obama and the G20: Is it 1933 all over again? BusinessWeek, 30 March 2009. 6 Jeffrey Frankel, Obstacles to international macroeconomic policy coordination. NBER Working Paper No. 25050. Cambridge MA, National Bureau of Economic Research, February, 1988. 7 Barry Eichengreen, Should there be a coordinated response to the problem of global imbalances? Can there be one? DESA Working Paper No.69. New York, United Nations Department of Economic and Social Affairs, September, 2008. 8 Frankel, Obstacles to international macroeconomic policy coordination.

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values of the target variables should be (for example, what size and sign of current account balance); what the appropriate policy measures should be (for example, the balance between fiscal consolidation, exchange rate adjustment and so forth); and agreement on the impact of those changes (for example, the size and sign of the impact of a given exchange rate on the current account balance – that is, agreement on the underlying economic model).

­ Stage 2: the countries must negotiate how the gains from coordination will be shared.

­ Stage 3: The final agreement must be enforced, including a way of monitoring adherence to the agreement and a policy on what should be done if either party fails to live up to its commitments.

It seems clear that, in the current context, all three stages are going to be problematic.

Start with Stage 1. First off, we have no agreement on the nature of the problem. There is ongoing debate over the extent to which global imbalances are a risk to the global economy, and over whether they were a significant contributor to the global financial crisis (GFC). There is no clear agreement on what a sustainable current account surplus or deficit is, let alone what the ‘optimum’ value of those variables should be. And there is no agreement on policy tools or the underlying model. For example, there are bitter disagreements over whether exchange rate adjustment will ‘work’, and over how far China’s current exchange rate is from its equilibrium value. Making progress even on these first steps looks tough.

Things look little better with Stage 2. Here, the increased size of the negotiating club (G20 vs. G7 – or actually G5 in the case of Plaza) and the increase in membership heterogeneity both serve to make reaching agreement even harder than in the past.

A further complication here is that countries have to be able to deliver on the agreements they agree to. But remember, for example, that the US was either unwilling or unable to deliver on the fiscal adjustment that it had agreed to as part of the Plaza Accord.

This brings us neatly on to Stage 3, and enforcement, which seems to present insurmountable problems. Perhaps most plausible option for an enforcement mechanism is something based on peer review. But going on past performance, this is unlikely to deliver: The IMF’s Multilateral Consultation on Global Imbalances was a complete failure; Likewise the EU’s process for monitoring fiscal sustainability – as recently evidenced by the Greek debacle; And effective peer review has not even been a starter in East Asia. Arguably the only success has been the OECD’s process.

Yet if peer review is unlikely to deliver, what is the alternative? Some have suggested tougher measures, including for example levying taxes on the debt of non­complying deficit countries or imposing tariffs on imports from, and subsidies on exports to, surplus countries. 9 But reaching international agreement on trigger levels for these

9 Anne O. Krueger, Persistent global imbalances, in Rebalancing the global economy: A primer for policymakers, ed. Stijn Claessens, Simon J Evenett, and Bernard HoekmanvoxEU.org, 2010.

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penalties would be extremely tough, and unilateral imposition (aka trade wars) seems a more plausible outcome. Finally, some version of the Keynes Plan for an international clearing union also seems out of reach. 10

Depressed global growth?

There is certainly a good case to be made for the proposition that we are in for a prolonged period of sub­par global growth. The idea that the developed world in particular is facing a ‘new normal’ characterised by lower growth rates, more debt, higher unemployment, tougher regulation, greater government intervention and a reduced tolerance for risk has gained a lot of traction. 11

There is also some empirical support for this gloomy outlook. The IMF, for example, has looked at the history of financial stress and economic cycles in 17 advanced economies over the past 30 years, and identified 113 episodes of financial stress. 12 A review of these 113 episodes saw the Fund conclude that slowdowns and recessions that were preceded by financial stress episodes have tended to be both longer in duration and, partly as a result, more severe, than those that were not. Similarly, a related IMF study looked at recessions and recoveries in 21 advanced economies over the past 50 years. 13 This research confirmed the finding that recessions associated with financial crises have tended to be more severe and longer lasting than recessions associated with other shocks. Recoveries from these recessions have also tended to be slower, associated with weaker domestic demand and tight credit. In addition, recessions that are highly synchronized across countries have been longer and deeper than those confined to one region, with weaker recoveries.

Since the GFC has been both highly synchronized and triggered by a deep financial crisis, these findings are bad news for global growth prospects: history would indicate that we should expect not only the severe downturn that we have already suffered, but also a sluggish recovery. Recent work by Reinhart and Reinhart also suggests that economic growth is typically subdued in the decade following an adverse macro­ economic shock. 14

But if the outlook for the developed world looks grim, what about the prospects for emerging markets? After all, these economies have become increasingly important drivers of global growth over recent years, due to a self­reinforcing combination of rapid growth rates and a rising share of global output. Can’t emerging markets be relied upon to lift global growth?

10 On the Keynes plan, and a proposal to update it for contemporary circumstances, see Vijay Joshi and Robert Skidelsky, Keynes, global imbalances and international macroeconomic reforms, today, in Rebalancing the global economy: A primer for policymakers, ed. Stijn Claessens, Simon J Evenett, and Bernard HoekmanvoxEU.org, 2010. 11 On the ‘new normal’ see for example Mohamed El­Erian, A new normal. Secular Outlook, PIMCO, May, 2009. 12 International Monetary Fund (IMF), Financial stress and economic downturns, in World Economic Outlook: Financial stress, downturns and recoveries. Washington DC, International Monetary Fund, 2008. 13 International Monetary Fund (IMF), From recession to recovery: How soon and how strong?, in World Economic Outlook: Crisis and recovery.Washington DC, International Monetary Fund, 2009. 14 Summarised in Carmen M Reinhart and Vincent R Reinhart, Diminished expectations, double dips and external shocks: The decade after the fall. VoxEU.org, 13 September, 2010.

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The rise, fall and rise again of decoupling

With emerging market growth significantly outpacing growth in developed economies since the start of the current millennium, the original answer to this question was an optimistic one.

The theory of decoupling asserted that, such was the shift of growth momentum in favour of the emerging markets, the latter would increasingly become independent poles of growth in the global economy. Emerging markets’ reliance on the developed world to be an external driver of their economic performance would decline and as result, their economic growth – and hence their financial markets – would decouple. 15

Initially, the argument seemed to have some merit: even after the bursting of the US subprime bubble in mid­2007 and then on into early 2008, there was little sign that growth was suffering in emerging markets. Indeed, even as the Fed cut US policy rates in an attempt to shore up activity, policymakers in several key emerging markets were tightening policy in response to worries about over­heating. And emerging economy financial markets also appeared to be resilient, continuing to rise until around November 2007.

The failure of Lehman Brothers and the economic chaos that followed prompted a rethink. In the immediate aftermath of September 2008, the decoupling thesis looked nonsensical: as global trade and capital flows collapsed, growth crashed in both emerging markets and developed economies. Indeed, the size of output declines in many emerging markets significantly exceeded those experienced by the United States and the United Kingdom, which were right at the epicentre of the crisis.

Since then, however, the success of China in particular, and to a lesser extent India, in delivering positive economic growth in 2009, together with signs of a V­shaped recovery in some other emerging markets, means that the decoupling thesis has made a comeback, albeit in a more modest version than its earlier incarnation: the idea of relative invulnerability to a major rich country shock has been buried, but the prospect of significant growth outperformance remains. 16

One useful way of thinking about this is in terms of a distinction between cyclical and structural decoupling. 17 The synchronized fall in global activity after September 2008 confirmed that cyclical ‘coupling’ is still a reality. But the sustained growth out­ performance by emerging markets both before and after the crisis suggests that structural growth rates may well have decoupled from the developed world. That in turn should provide at least some cause for a bit of cautious optimism to apply to what would otherwise be a rather dismal global outlook.

15 M. Ahyan Kose, Christopher Otrok and Eswar Prasad, Dissecting the decoupling debate. VoxEU.org, 4 October, 2008. 16 Peter Stein, Asian growth revives 'Decoupling' Concept. The Wall Street Journal, 14 September 2009. 17 See for example Otaviano Canuto, Recoupling or switchover: Developing countries in the global economy. Washington DC, The World Bank, 2010.

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References

Bergsten, C. Fred. A call for an "Asian Plaza". The International Economy, Spring 2008, pp 12­15, 70.

Canuto, Otaviano. Recoupling or switchover: Developing countries in the global economy. Washington DC, The World Bank 2010.

Cline, William R. The case for a new Plaza Agreement. Policy Briefs in International Economics PB05­4. Washington DC, Institute for International Economics, December 2005.

Eichengreen, Barry. Should there be a coordinated response to the problem of global imbalances? Can there be one? DESA Working Paper No.69. New York, United Nations Department of Economic and Social Affairs, September 2008.

El­Erian, Mohamed. A new normal. Secular Outlook, PIMCO, May 2009. Financial Times. A survival plan for global capitalism. Financial Times, 8 March

2009. Frankel, Jeffrey. Obstacles to international macroeconomic policy coordination.

NBER Working Paper No. 25050. Cambridge MA, National Bureau of Economic Research, February 1988.

Gilpin, Robert. The rise of American hegemony. In Two hegemonies: Britain 1846­ 1914 and the United States 1941­2001, edited by Patrick Karl O'Brien and Armand Clesse, pp 165­182. Aldershot, Ashgate Publishing Ltd, 2002.

International Monetary Fund (IMF). Chapter 4. Getting the balance right: Transitioning out of sustained current account surpluses. In World Economic Outlook: Rebalancing growth. Washington DC, International Monetary Fund, 2010.

———. Financial stress and economic downturns. In World Economic Outlook: Financial stress, downturns and recoveries, pp 129­158. Washington DC, International Monetary Fund, 2008.

———. From recession to recovery: How soon and how strong? In World Economic Outlook: Crisis and recovery, pp 103­138. Washington DC, International Monetary Fund, 2009.

Joshi, Vijay and Robert Skidelsky. Keynes, global imbalances and international macroeconomic reforms, today. In Rebalancing the global economy: A primer for policymakers, edited by Stijn Claessens, Simon J Evenett and Bernard Hoekman, voxEU.org, 2010.

Kose, M. Ahyan, Christopher Otrok and Eswar Prasad. Dissecting the decoupling debate. VoxEU.org, 4 October 2008.

Krueger, Anne O. Persistent global imbalances. In Rebalancing the global economy: A primer for policymakers, edited by Stijn Claessens, Simon J Evenett and Bernard Hoekman, voxEU.org, 2010.

Kuroda, Haruhiko. The "Nixon Shock" and the "Plaza Agreement": Lessons from two seemingly failed cases of Japan's exchange rate policy. China & World Economy 12 (1) 2004, pp 3­10.

LeVine, Steve. Obama and the G20: Is it 1933 all over again? BusinessWeek, 30 March 2009.

Reinhart, Carmen M and Vincent R Reinhart. Diminished expectations, double dips and external shocks: The decade after the fall. VoxEU.org, 13 September 2010.

Stein, Peter. Asian growth revives 'Decoupling' Concept. The Wall Street Journal, 14 September 2009.